Hedging Strategy Learn What Are Hedging Techniques At CAPEX.com

A hedging strategy is essentially a form of insurance when you are trading. When it comes to trading, you can’t pay an insurance company and they provide you a hedging strategy. You need to learn this craft yourself.

Hedging strategies are the most strategic type of instruments as they require you to use the trading instruments at your disposal to offset the risk of any sudden price changes or downward market trends. You position one trade against another to secure yourself if the first trade goes wrong. This does require you to take a negative position, whether that’s in security or  futures, in order to offset your original position going bad.

An example of a hedging strategy

Here’s an example of a hedging strategy. You want to buy some long shares in Apple. You can buy a put option – which gives you the option to short sell long shares. However, Apple will charge a premium on your put option. This is the principle of loss of risk and equal loss of profit. So, a great hedging technique aims to prevent exponential losses.

Short selling

• Little capital: When using as a hedging strategy, you don’t need that much capital to short sell instruments for protection. The opportunity of volatility means your hedging strategy could see your hedge rise quickly in profit, therefore quickly providing protection for your investment.
• Leverage: Margin trading, when you borrow from a broker to make a trade. This method of short selling offers leverage to your trade, which will up the value of your hedging strategy, and therefore offer more protection in the long run. Remember that at CAPEX you’ll be able to use leverage.
• Control: When short selling and buying again, you’re always in control of your hedging strategy. You’re not locked in for the long run, so the ability to set stop losses, or sell at a whim will come as a huge advantage for a hedging technique to prevent any sudden losses.

Futures contracts

• Minimises volatility: The primary goal of futures contracts is to lock yourself into a price rate that you will be a fixed purchase for your trade. This works brilliantly as a hedging strategy, as it makes sure any sudden changes in price in your trade will not have any effect on your position.
• Uncertainty: Once you purchase futures for your hedging strategy, it takes away any uncertainty that comes with the trading market. Any market trends, any shifts in value become redundant – your futures contract makes sure the market will not upset the balance of your asset.
• Easy to sell: Once you feel you no longer have any use for the protection of a futures contract, selling the contract is simple and can be done at any time before an expiration date. However, once you sell, you will have to pay the cost of the futures contracts in order to close them.

Short Selling

• Unlimited losses: Even as a hedging strategy, the potential for losses when short selling is unlimited. If you are not focused enough and hold onto a trade for a moment too long, it could result in drastic losses. It’s important to take care and be focused when short selling
• Borrowed money with margin trading: Margin trading does secure leverage, but because you are borrowing the money, it also means more cost and less control over your hedging technique. You’ll have to meet a minimum maintenance fee of 25%, which can easily get out of control and get costly if you fail to pay it
• Wrong timing: If you don’t buy your trade at the right time, it could hypothetically take some time for the trade to start declining in value. This means you could be subject to interest, any margin charges and the trade serving as more costly than protective.

Futures

• Missed opportunities: Using futures as a hedging strategy can see some downfalls if you’re timing isn’t correct. Once you buy the contract, you could miss out on some favourable price changes in the market, and your trade will still be the same value as it was when you hedged it.
• Standardized contracts: Futures contracts may decay your hedging strategy as there are certain terms in the futures contracts that may never be met, but are standardized as a part of the contract. For example, the contract size, and expiry date may have an adverse effect on the potential protection the futures contract has as a hedging technique
• Legal obligation: A futures contract is a contract, which means it is legally binding. There is no way out of performing what is stated in the contract, even as a hedging technique. For example, if your investment falls through, you are still legally bound to your futures contract, so it just becomes speculative.

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1.  Short Selling – Why short selling is an effective hedging technique

Short selling is taking a position to sell an asset when the trader believes it will fall in value. You then buy at a future date at a lower price, or when the trade has become more stable. It’s a hedging strategy that is often used with cryptocurrency, when trading at a crypto online broker platform such as ours at CAPEX, as it prevents the long term losses when you take a long position with a trade.

We’d recommend you’d use short selling for unstable trades. The likes of crypto, stocks and Forex will see drops in price regularly, and short selling on these instruments will provide good security and establish a solid hedging strategy. However, it is essential to set up stop-losses here. Hedging techniques in forex will require stop losses because currency trades will always have volatility. Do not expect to make a large amount of profit. It functions great as a hedging strategy for protection of investments, but that’s it.

2.  Futures – Why Futures are a profitable hedging strategy

A futures contract is a legal agreement to buy or sell a particular asset at a predetermined time in the future. It differs from short selling as the time is fixed – allowing for a more stable, but inflexible hedging technique. Most traders rely on futures contracts when they are taking long positions in a trade. Futures contracts are far more useful for more stable and fixed instruments, such as commodities, bonds and indices, which you can trade at CAPEX. Take for example, you want to invest big and buy 20 pounds of gold for $12 per ounce.

You can also buy a six month futures contract as a hedging strategy. As a result of that, you guarantee the price is fixed at $12. So, it does not matter if the market sees a sudden rise of gold value – you’ve protected yourself with the futures contract. It’s a technique that requires patience and capital.

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